POTASH GROWTH TOO FAR, TOO FAST
Flatlining demand leaves producers with excess capacity.
Ten years ago, when Bill Doyle embarked on one of the biggest production expansion programs in the history of the potash business, there was an obvious rationale: The global population is rising, and the world has limited arable land to grow crops. More potash will be needed.
A decade later, that thesis remains as true as ever. But the logic of the expansion is not so obvious.
The shareholders of Mr. Doyle’s company, Potash Corp. of Saskatchewan Inc., cannot help but think about two key numbers: nine and 17.
Nine million tonnes is Potash Corp.’s anticipated production level in 2013. Thanks to those expansion projects, its capacity will be 17.1 million tonnes by 2015. Even this year, Potash Corp.’s production will not come close to its capacity of 12.8 million tonnes. So what will it do with 17?
It is fair to say that this is not the scenario Mr. Doyle envisioned when he greenlighted the $8.3-billion expansion a decade ago. If even some of that money was returned to shareholders instead, they would have been ecstatic.
It has led some onlookers to suggest that Potash Corp. and other producers, which are also ramping up production, have expanded too far and too fast, costing themselves pricing power.
“In hindsight you could say that,” said Fai Lee, an analyst at Odlum Brown. “But at the time, [the expansions] seemed to make sense because demand was growing at a reasonably steady pace. Call it 4%.”
The problem is that demand unexpectedly flatlined in the past several years, leaving the industry with too much capacity. Oversupply has become a major concern for investors and contributed to the negativity surrounding the sector, despite forecasts of higher demand this year.
“There has been zero potash demand growth in the last eight or nine years. Zero,” said National Bank analyst Robert Winslow. “And while demand has been flat, supply has been rising.”
Mr. Lee said global production capacity has grown by about 10 million tonnes since 2007, despite flat demand. And Mr. Winslow calculated that supply will grow an additional 4% per year through 2017.
They got too aggressive. They
overplayed their hand
This is what he calls “high-probability” supply, meaning it comes from existing producers. It does not even account for potential new entrants like bHP billiton Ltd., which wants to build the world’s largest potash mine by far.
It raises the question of when demand will finally catch up to supply, and how much idled production the industry will be stuck with in the meantime. The more excess capacity there is, the tougher it will be to raise prices.
concerns about overcapacity intensified in July, when russian potash giant OAO Uralkali dismantled a cartellike marketing company and vowed to max out production and seize market share (though the plans are subject to russian politics and could easily change). If the rest of the industry follows that path, it is easy to imagine a market over-stuffed with potash.
Of course, the capacity expansions have benefits. They lower costs and make it easy for the potash companies to ramp up production once the market needs it. even the most bearish analysts agree that this supply will be required one day.
but that day is farther off than the potash oligopoly expected 10 years ago.
There are two key explanations for why the producers misjudged demand, according to experts. One was unforeseeable, while the other was at least partly self-inflicted.
The unavoidable issue is India, one of the most import- ant potash importers. Over the past few years, the Indian government has pushed a subsidy program that encouraged farmers to use nitrogen over potash and phosphate, creating massive distortions in the fertilizer markets. The issue was compounded this past summer, when the rupee plunged against the U.S. dollar and made it tougher for India to import anything. The government also slashed its potash and phosphate subsidies in May to try to lower its deficit.
It is not healthy for crops to apply an unbalanced mix of fertilizers, and India will eventually adjust. but for now, the impact on the potash market is undeniable. India should probably import at least three million more tonnes of potash this year than it actually will, which is a significant amount in a market of roughly 56 million tonnes.
“When you have a big importer like that taking a hiatus for two years, it really puts a kink in the demand theory,” said an analyst, who asked not to be named.
The other problem, experts said, is the producers pushed prices too high, particularly in 2007 and 2008 when the market was peaking, leading to demand destruction.
“What happened is they got too aggressive,” said Mr. Winslow. “They overplayed their hand.”
Prices topped US$900 a tonne at the peak of the potash frenzy, which was more than triple any historical norm. That encouraged farmers to draw down inventories and delay purchases and angered key customers like china and India that have been slow to sign sales contracts.
Prices are around US$400 a tonne today, which is a solid level by any historical standard. but Uralkali warned that its new volume-over-price strategy could push them down 25% to US$300.
The concern going forward is that negotiating higher prices will only get tougher for the producers. While Uralkali may pull back on its strategy, the company’s open admission that prices could be much lower will not be forgotten by customers, particularly when there is so much new capacity coming onstream. The industry is operating at around 70% of its capacity right now, a relatively weak level that will get worse if demand does not improve.
While investors are now worried about excess capacity, they were very much in favour of the expansions for most of the last decade. One of the reasons the strategy made sense for the potash producers is that they got premium valuations if they had good growth prospects.
“They had all this capital, this amazing share price, and these North American shareholders that were looking for growth. So you find a way to give it to them. That’s not a mistake made by potash company managements. That’s doing what their shareholders have asked them to do,” said Jed richardson, a former potash executive who now runs the phosphate company Great Quest Metals Ltd.
regardless, he does not think there was a good business logic for such a huge capacity expansion program, saying it was simply too big for demand to absorb.
Potash corp. argues that these concerns are way overblown. In a presentation last week, cFO Wayne brownlee said offshore demand has grown at a reasonable rate of 3.5% over the past five years after India is stripped out. He also pointed out that the industry is usually in an oversupply situation. That hasn’t prevented the oligopoly from making money in the past by matching supply with demand.
Mr. doyle, in his usual bombastic manner, shrugs off the notion that it is even an issue. “I think the market is going to be surprised to learn that this tremendous overcapacity that everybody talks about won’t be there,” he said in February.
And despite the Uralkali-induced negativity surrounding the sector, Mr. doyle’s old selling points are as relevant as ever. He can point to United Nations figures predicting that the global population will rise 33% to 9.6 billion people by 2050. He thinks food production will have to rise by 70% to feed them.
Five or 10 years from now, Potash corp. may decide that 17.1 million tonnes is not nearly enough. but for investors looking at a market with disappointing demand and downside pressure on prices, that day seems awfully far away.